The Turning Point

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Blockbuster Corp. has looked at life from both sides now. When it leaped out of the gate in 1985, it quickly swallowed its mom-and-pop competitors to become the dominant player in the fast-growing video-store industry. Today, it faces the grimmer side of the corporate life cycle as emerging technologies and delivery systems threaten the demise of video stores altogether.

Industries have been dying at least since the Middle Ages, and often because a new technology (cars, in the case of buggy whips) or product (petroleum, in the case of whaling) made the old industry obsolete.

For Blockbuster, it is video on demand and digital downloading that threaten to make its business proposition obsolete. PCs put Smith Corona on the critical list. Electronic banking may spell the end of check printer Deluxe Corp., based in St. Paul, Minnesota.

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As different as these companies are, each is facing or has faced the same conundrum: in a mature industry, should a company aggressively pursue transforming technologies or simply ride out its current business model? The choice is far from clear-cut. History shows, for example, that it is easy to get entrenched in existing technology—even when change is bearing down. “A lot of times, the train doesn’t look like it’s coming at you that fast, and sometimes that’s because you’re looking at it head-on,” says Bert Ely, a banking industry consultant with Ely &Co., in Alexandria, Virginia.

Human nature is also a hindrance, since “people in a legacy business want to hang in there,” adds Ely. Moreover, the cost to move to an industry-changing technology can be prohibitive to the company—and to its shareholders. As Deluxe CFO Doug Treff points out, sometimes “shareholder value is the ultimate driver of decisions—more important than survival of the company.”

Blockbuster has every intention of surviving. Yet, while chief competitor Netflix is investing aggressively in pay video-on-demand (VOD) delivery, Dallas-based Blockbuster is mostly focusing on extracting every cent from the home DVD-rental market—seeking acquisitions, boosting its online DVD-rental services, launching a subscription program similar to Netflix, and creating a DVD trade-in program. And why shouldn’t it? In its most recent quarter, the world’s largest video-rental chain posted more than a 6 percent increase in revenue over the previous year. Sure, there have been rough spots: Blockbuster’s planned acquisition of Hollywood Video was still under intense scrutiny by the Federal Trade Commission at press time, for example, and it is being sued by the state of New Jersey over its new “no late fees” policy. But publicly, executives say critics are just trying to throw cold water on a profitable business proposition.

“We’ve been hearing about the ultimate demise of Blockbuster for years,” says Blockbuster CFO Larry Zine. “All we’ve heard about is the threat of video on demand and how that is going to put us out of business. What happened in the interim is something that gives us a lot of comfort in the future.” What happened in late 1999 was Blockbuster’s introduction of DVDs, which were cheaper to store, ship, and save than VHS tapes. More important, says Zine, people still love the “experience of the Blockbuster store,” a habit that he says will keep Blockbuster’s DVD-rental model viable for some time.

(Blockbuster did launch a highly publicized trial run of a video-on-demand joint venture with Enron Broadband Services, a division of Enron Corp., in July 2000. The trial was suspended after eight months, and Blockbuster has not reentered the VOD marketplace since that time.)

It’s Just Not Happening

As Zine’s comments illustrate, finance executives in challenged industries are in a precarious position. Publicly, they must tout their companies’ commitment to innovation and long-term goals. Yet instead of investing in new technology, they can become enamored of their current business model—especially if it is successful. And their unrelenting focus on shareholder value can blind them to the fact that they may be facing a Waterloo moment.

That’s partly what happened to Smith Corona. The company had been making typewriters for more than a century as it sank into the sunset—kicking the whole way. Despite tough times in the early 1980s due to overseas competition, Smith Corona was soaring late in the decade after it was acquired by Hanson Trust Plc, posting its best year in 1989. That same year, though, Hanson (apparently recognizing what Smith Corona’s executives would not) spun off the typewriter division as a separate entity. Shortly thereafter, the company was run over by the personal-computer revolution.

It wasn’t that Smith Corona didn’t see the PC coming. In 1991, the company actually partnered with Acer, a Taiwanese manufacturer, to make what was lauded as one of the most user-friendly PCs yet built. But the market was already filled with Johnny-come-latelies when Smith Corona got in. The venture faced severe price competition, and most telling—the Smith Corona board killed it after a year because the product line wasn’t growing fast enough. In November 1992, the company’s CEO, G. Lee Thompson, told the Wall Street Transcript, “Many people believe that the typewriter and word-processor business is a buggy-whip industry, which is far from true. There is still a strong market for our products in the United States and the world.” When asked what new products and services the company planned to introduce, he replied, “Nothing right now. They’re still in the formative stages.”

Smith Corona grossly misjudged the public’s preference for PCs, contends one former company executive. “It was a decision made without a lot of vision as to what the computer was going to be,” says Mike Chernago, former vice president of operations, who believes the Acer machine could have saved the company. “People screamed like crazy when they killed that deal. But at the time, the executives thought that Smith Corona was never going to be put out of business. It was hard to imagine that the typewriter would be annihilated in just 10 years.”

In contrast, Remington Rand acted on the next big thing. The company, which produced the first commercially available typewriter in 1873, also made the first business computer, the 409 (sold as the Univac), in 1949. After merging with Sperry Corp. to form Sperry Rand in 1955, the company sold off the Remington Rand typewriter division in 1975, years before the PC was a threat. It was a fortuitous move: Remington Rand Corp. went bankrupt in 1981. Meanwhile, Sperry Rand thrives in its latest incarnation—as computer-services giant Unisys.

A Checkered Approach

Smith Corona illustrates that insight into a changing industry is useless unless it is followed by preemptive, definitive action—even if shareholders seem unimpressed.

Like typewriters, the paper-check industry has been under fire for decades, as consumers turn to electronic banking. But only in recent years have the biggest players begun to react. In fact, industry leader Deluxe made 90 percent of its revenues from checks up until fiscal-year 2003, and continues to unveil paper-check-related services.

In the mid-1990s, the company made a Smith Corona­-like stab at acquiring companies in the electronic-payments field. But Deluxe CFO Doug Treff, who was not with the company at the time, says that shareholders were not enamored of the strategy. “Our shareholders are value-oriented, and the electronic companies were more growth-oriented,” says Treff. Lack of sell-side coverage made it hard to get the word out that the acquisitions were part of a long-term strategy, he adds. So, instead of tolerating short-term stock pressure in order to diversify, the company consolidated the acquisitions and spun some of them off as a tax-free distribution to shareholders (called eFunds).

“Check printing was such a large contributor to profitability and cash flow,” says Treff, that the company was ultimately unwilling to contribute to the demise of the sector by embracing electronic-fund technology. But, he admits, “the spin offs left us with a company focused on the paper check.” In other words, back at square one with no long-term diversification plan.

Deluxe then made the traditional moves to boost earnings per share: it cut costs, closed manufacturing facilities, and bought back shares. Finally, in June 2004, Deluxe purchased New England Business Service (NEBS), a forms, office-supply, and stationery manufacturer. As a result, in the third and fourth quarters of 2004, print-check revenues accounted for 75 percent of total 2004 revenues, and the firm posted an 18.8 percent increase in its fourth-quarter profits.

Still, 75 percent amounts to a dangerously high portion of revenue dependent upon a vanishing consumer activity. In 2003, according to the Federal Reserve Board, Americans for the first time conducted more transactions using debit cards, credit cards, and E-billing than they did using paper checks. Although NEBS may prove a sound acquisition from a shareholder-value standpoint, it might not ultimately guarantee Deluxe as a going concern.

Treff, it seems, is OK with that. Yet, while he may hold shareholder value in the highest regard, the CFO, who joined Deluxe in late 2000, maintains that it “has to be looked at in the long term.” And, he adds, “We do make investments that don’t pay off right away.” Meanwhile, eFunds is trading at 23, double its opening share price.

In comparison, Deluxe’s main competitor, Atlanta-based John H. Harland Co., has spent the past few years acquiring electronic-funds and data-processing, testing, and software companies, and reinventing itself as a software and services provider. Its shareholders have supported the acquisitions, which led to reduced earnings in 2004. Harland’s stock has jumped 30 percent in the past three years, compared with Deluxe’s, which dropped about 15 percent over the same period.

Ultimately, a Crapshoot

In the immediacy of the moment, no one can tell which choices are sound and which fatal. In the DVD-rental market, this uncertainty is compounded by the fact that the two category leaders, Blockbuster and Netflix, are betting on what a feeder industry—in this case, the movie studios—will do.

Currently, those studios make 50 percent of their gross profits on DVD sales and $2.5 billion annually from DVD rentals, a revenue stream guaranteed by well-guarded distribution channels. Once a movie has ended theatrical release, for example, it is sold or rented via Wal-Mart, Blockbuster, Netflix, or similar outlets for between 30 and 60 days or more. Only after that does the film go to pay-per-view and pay VOD. The film moves into the cable film channels and free VOD after that channel has gone cold, and finally ends up on regular TV. “The studios are very good at adding distribution channels,” says Dennis McAlpine, an entertainment-industry analyst. “They don’t eliminate channels when something new comes along.”

Blockbuster is staking its future on traditional DVD rentals in stores and online. To CFO Zine, the threat posed by VOD will be thwarted in several ways. (Blockbuster, which was spun off from Viacom Inc. last October, has not yet generated annual earnings as a company, due to write-downs, accounting changes, and other noncash adjustments.) He argues that Blockbuster receives new releases before VOD services, it has a bigger library of titles than VOD, and its DVD technology offers higher production values than VOD movies. Most important, movie studios don’t think VOD is a big revenue generator. “The studios would have to hope for a fivefold increase in VOD rentals before VOD would really become a viable channel for them,” says Zine.

That may be more likely than Zine predicts. According to Derek Baine, an analyst with Kagan Research, several studios have begun to make some films available on pay VOD simultaneously with home DVD rental. “They want to see what happens to their DVD sales when they move up the window for pay VOD,” says Baine. If DVD sales aren’t affected, the home DVD-rental business could face far more of a threat than it does at present.

Of course, DVD-rental companies could always counter this threat by getting into VOD themselves. Netflix has already pounced. The company, which just hit 2.5 million subscribers and posted earnings of $4.8 million on revenues of $144 million for 2004, announced an alliance with TiVo, the digital video recording service with 2.3 million subscribers, to create a “digital entertainment product.” Although Netflix won’t say much more than that, the service will reportedly allow customers to order a movie online at Netflix.com, which will then be loaded onto their TiVo sets, providing DVD-quality movies on demand. The combination of delivery channel, quality, and selection could dramatically change the business proposition for Blockbuster.

There’s no guarantee Netflix will succeed, either. Licensing hurdles could be a deal-breaker. But standing still equals failure, eventually. And Netflix seems willing to put long-term survival ahead of short-term shareholder concerns: its stock was trading at $10 in early March, down precipitously from its all-time high of 38 in April 2004. Despite the hits, Netflix CFO Barry McCarthy is currently investing 1 to 2 percent of revenues into digital-downloading technologies, which, coupled with a recent subscription price cut, should lead to a loss for 2005. “But it’s potentially important for our future,” says McCarthy. “The only way to have a seat at the table is to test the proposition with consumers, figure out the best model, then rapidly innovate as you learn more about the consumer proposition.”

McCarthy is unsure how long it will be before digital downloading and VOD become a “meaningful component of our revenue stream. It will come slower than people think.” He says this is partly due to the difficulty of licensing digital content from studios loathe to mess with their precious DVD sales and rental revenue, and partly to the challenges of the technology required to download high-quality movies. Also at play is the price point for the “boxes” that would store the downloaded movies. Still, the TiVo alliance goes a long way toward painting a picture of how home movie rental may soon look.

In contrast, Zine says that Blockbuster takes a more cautious approach to new technologies, often buying smaller companies that are engaged in that technology, and “learning lessons” from them that they eventually incorporate into their own business model. For instance, two years before getting into online rentals, it bought a small online company, Film Caddy, and studied its operations. Only then did it unveil Blockbuster Online.

Blockbuster also purchased a small company specializing in movie trading before introducing trading to its stores. And it launched VOD tests in the United Kingdom and the United States before announcing during its annual conference call in March that it plans to launch its own VOD service on Blockbuster Online in 2006—although it had no details about how it would work, or what delivery mechanism would be used.

The company, which is now appearing to embrace VOD as a potential new business line, was far from enthusiastic about it just two weeks earlier when Zine said of VOD, “we don’t think the economics work well right now.” Instead, the CFO said, the company was focused on boosting revenue through its online and in-store subscriptions program (a replica of Netflix’s program), same store rental revenue through elimination of late fees (a concept also pioneered by Netflix), its DVD trading program, and the transformation of some of its stores into “gaming” venues, which allow customers to rent video games before buying them. It appears that someone at Blockbuster got the message that VOD is a space in which, economics or not, Blockbuster must be.

Smoke and Mirrors?

In truth, nonchalance about impending technology may conceal aggressive behind-the-scenes moves. Whether that is the case with Blockbuster, or if there is simply a hesitance to embrace the next big thing, remains to be seen. Without a significant shift in the studios’ distribution strategy, analysts predict, Blockbuster can continue to grow revenue by a couple of percentage points a year for the foreseeable future. Ironically, analysts said the same about Smith Corona, predicting that an established base of typewriter customers would never move to PCs, including a large overseas market. The company sold its assets for $6 million in 2000.

Blockbuster does appear to be doing a few things right, says Kathryn Rudie Harrigan, Henry R. Kravis Professor of Business Leadership at Columbia University Graduate School of Business. “You need to love your laggards,” she says. Customers who are laggards don’t switch over to new technology right away, she explains. Instead, “make it very convenient for them. Make it so they are reluctant to switch to a new product. Eliminating late fees is a great way to get people to go to video stores.”

But the key to survival in a contracting industry, says Harrigan, is “to become diversified and to evolve as your customers evolve. Define yourself broadly enough to develop other products, some of which may make your older products obsolete.” This means CFOs must put aside some of the cost-cutting and EPS-boosting tools they use to pull companies through tough times in more-robust industries. They must make the argument to shareholders and to Wall Street that long-term investment in emerging opportunities is more important than short-term stock price.

What CFOs can’t do, she warns, is ignore obvious signs of industry contraction. Believing in your company is important, but CFOs must be active participants in learning all they can about the industry-killer next door. “It’s like a lot of things,” she adds. “If you let yourself get stagnant, if you’re not constantly reinventing yourself, you’re dead meat.”